Software cost cutting through modular design : Ericsson case study

Companies rely on global strategies to succeed in today’s world. That calls on a company to think of the world as one market instead of as a collection of national markets and sometimes requires decisions as unconventional as accepting projects with low ROIs because of their competitive payoff. An organization with such a global focus formulates long-term strategy for the company as a whole and then orchestrates the strategies of local subsidiaries accordingly.

L.M. Ericsson of Sweden has become a successful global competitor by developing and exploiting a technological niche. Most major international telephone-equipment producers operated first in large, protected home markets that allowed the most efficient economies of scale. The additional profits helped underwrite R&D and provided good competitive leverage. Sweden’s home market is relatively small, yet Ericsson translated the advent of electronic switching technology into a powerful global lever that befuddled competitors in its international market niche. In the electromechanical era of the 1960s, the telephone switching equipment business was hardly global. Switching systems combine hardware and software. In the electromechanical stage, 70% of total installed costs lay in hardware and 70% of hardware cost was direct labor, manufacturing overhead, and installation of the equipment.

Each country’s telephone system was unique, economies of scale were low, and the wage rate was more important than the impact of volume on costs. In the late 1960s, major international companies (including Ericsson) responded by moving electro-switching production to LDCs not only to take advantage of cheaper labor but also to respond to the desire of government telephone companies to source locally.

Eventually, each parent company centrally sourced only the core software and critical components and competed on a domestic-market-by-domestic-market basis. For its part, Ericsson concentrated investment in developing countries without colonial ties to Europe and in smaller European markets that lacked national suppliers and that used the same switching systems as the Swedish market.

The telecommunications industry became global when, in the 1970s, electronic switching technology emerged, radically shifting cost structures and threatening the market position Ericsson had carved for itself. Software is now 60% of total cost; 55%of hardware cost is in sophisticated electronic components whose production is highly scale sensitive. The initial R&D investment required to develop a system has jumped to more than $100 million, which major international companies could have amortized more easily than Ericsson. In addition, the move to electronics promised to destroy the long-standing relationships Ericsson enjoyed with smaller government telephone companies. And it appeared that individual electronic switching systems would require a large fixed-cost software investment for each country, making the new technology too expensive for the smaller telephone systems, on which Ericsson thrived.

Ericsson knew that the electronic technology would eventually be adapted to small systems. In the meantime, it faced the possibility of losing its position in smaller markets because of its inability to meet the ante for the new global competition.

The company responded with a preemptive strategic innovation—a modular technology that introduced electronics to small telephone systems. The company developed a series of modular software packages that could be used in different combinations to meet the needs of diverse telephone systems at an acceptable cost. Moreover, each successive system required fewer new modules. As Exhibit II shows, the first system—Sodertalje in Sweden—required all new modules, but by the third year, the Abo system in Finland required none at all. Thus the company rapidly amortized development costs and enjoyed economies of scale that steepened as the number of software systems sold increased. As a result, Ericsson was able to compete globally in small systems.

Exhibit II Ericsson’s technology lever: reduction of software cost through modular design Source: Boston Consulting Group, A Framework for Swedish Industrial Policy (Uberforlag, Stockholm, 1978).

Ericsson’s growth is accelerating as small telephone systems convert to electronics. The company now enjoys an advantage in software cost and variety that continually reinforces itself. Through this technology Ericsson has raised a significant entry barrier against other companies in the small-system market.

By Thomas Hout, Michael E. Porter & Eileen Rudden
Harvard Business Review, September 1982